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Accounting for revisions I

23 January 2014

Protection of a true and fair view in focus

One of the purposes of the Hungarian Accounting Act is the compilation of a report that is required to provide a true and fair view of the operation, the assets and liabilities, the composition of the assets and liabilities, the financial and equity position and the operating results of a business entity in a manner that accords top priority to the interests of those relying on the data disclosed in the report and those of market actors.

The Accounting Act is intended to cause businesses to observe the above in order to ensure the operational efficiency of a market economy, in which the quality of the information provided is instrumental. Global regulatory regimes cause these requirements to be met directly; in contrast, Hungarian legislation causes the principle of a true and fair view to be observed vicariously, through the fundamental accounting principles. A quality approach to information is influenced by the principle of materiality, which serves as a basis for the categorisation of accounting errors.

An accounting approach to revisions

Pursuant to Section 3(3)1 of the Accounting Act, revision means the subsequent inspection of the data of a financial year by either the economic entity or the tax authority following the approval of the annual report by the body authorised to do so within the framework self-revision or review by the tax authority. The findings of an revision mean the errors and their impacts. It is important to stress that the focus of this paper is the revision approach as defined in the Accounting Act; as a rule, corrections identified before the balance sheet date have tax law implications, which need to be resolved in the form of a self-revision return.

Legal convergence in the interest of ensuring that costs are matched against benefits (the principle of matching)

Errors and their impacts identified during revisions are categorised – on the basis of their magnitude - in accordance with the currently effective statutory regulations, with the principle of materiality serving as a basis for identification at the level of fundamental principles and in line with the above reasoning. The referenced principle [Section 16(4) of the Accounting Act] states that any information shall qualify as material from the point of view of the report the omission or erroneous presentation of which within reasonable limits influences the decision of those applying the data of the report. Harmony between data quality and magnitude approaches to it is embodied in the fundamental principle of matching costs against benefits.  Taking earlier regulations into account, the Accounting Act interpreted errors and their impacts identified during revisions at a dual level and treated them in accordance with their magnitude and differentiated between an error affecting the data of the report significantly and an error affecting the data of the report materially. With effect from 1 January 2013, the definition of a material error is no longer in use and the term “significant error” has, in part, been redefined as follows.

[Pursuant to Section 3(3)3 of the Accounting Act], whether an error qualifies as a significant one continues to be based on the balance sheet total pertaining to the revisioned business year, i.e. the year when the error occurred. A threshold value for significant errors is calculated as a percentage value in the company’s accounting policy unless the aggregate amount of all errors exceeds 2% (the highest value as specified in the referenced section of the Accounting Act). Under an earlier statutory provision, the threshold value for materiality was HUF 500 thousand if 2% of the balance sheet total was below HUF 500 thousand. Under the currently effective statutory regulations, the threshold value is HUF 1 million. Thus, overall, the threshold value of a significant error is a certain (not higher than 2) per cent of the balance sheet total for the year audited as set forth in the company’s accounting policy, but at least HUF 1 million.

The underlying reason for changes in legislation is a general trend in the Hungarian accounting regime aimed at the alignment of the size of businesses with their administrative burdens. One manifestation of this trend is the adoption of a simplified annual report for micro-businesses. In line with the modifications, the obligation to repeat disclosures in order to identify material errors was terminated and the rules effective before 2012 did not need to be applied even to the 2012 business year.

Quantification of errors and their impacts

Now that we have quantified the materiality threshold as a benchmark, let’s have a look at accounting for errors and their impacts. Accounting for errors and their impacts are regulated by Section 3(3) 3) and 4) of the Accounting Act discussed above. Pursuant to this section, accounting errors and their impacts affect assets and liabilities, operating profit or loss and equity, are related to a business year that has already been closed from an accounting point of view and stem from failure to apply or the inadequate application of the prevailing statutory regulations or from the erroneous interpretation of such regulations or from committing actions that are not permitted or outright forbidden. It is important to emphasize that in the course of the totalling of the errors and their impacts thus identified, they are the sum, independent of the sign preceding it, of the items increasing or decreasing profit or loss (operating results) and equity, i.e. the applicable law does not allow netting in accounting in this case either. It is important to note that corporate tax implications must also be taken into account; by contrast, the impact of neither self-revision charges, nor default penalties is to be taken into consideration despite their impacts on profit or loss. Errors are evaluated and categorised annually with respect to the periods audited. In practice, this means that if an error whose impacts - owing to the very nature of the error - affect more than one business year is identified, evaluation and categorisation need to be performed separately for each year.

The accounting treatment of the errors identified

As was mentioned earlier, in the case of the accounting treatment of errors and their impacts, it is essential that the date of the identification of errors be benchmarked against the balance sheet date. The categorisation and treatment of the errors linked to a closed business year are in the focus of an accounting revision. Subsequent to the enumeration of the errors and their impacts and the calculation of a threshold value for materiality, categorisation can be performed, whereby, ultimately, significant and non-significant errors are identified. Fundamentally, an approach to the accounting treatment and the presentation in the report of errors is whether or not the inclusion of errors and their impacts in the profit or loss for the reporting (current) period provides a true and fair view of the business entity’s financial and equity position, i.e. whether the Accounting Act recognises it as a component of the profit or loss for the given business year. Irrespective of categorisation, an error and its impacts must be presented synthetically under a separate general ledger number and recorded separately. It is important to emphasize that errors must, in all cases, be recorded in accordance with their economic content, i.e. they must be stated under (separate) general ledger numbers in the balance sheet and profit and loss accounts.

No error representing a material amount can be included in the profit or loss for the business year when the error is identified; accordingly, profit and loss accounts affected by a revision and those for the reporting (current) year are closed separately and presented separately in the report. The balance sheet and the profit and loss accounts containing the data of the revision comprise, in addition to a column for standard customary data on the reporting (current) period and one for standard customary data on the year preceding it, a third one (a middle one in accounting parlance) for adjustments for the preceding year/previous years.

A three-columned balance sheet presents the data of the preceding financial year in a manner that, in conformity with the opening data of the asset and liability accounts for the reporting (current) period, they correspond to the closing data in the report on the preceding business year. The column in the middle contains the changes of the individual asset and liability accounts affected by the revision. It is important to stress that errors and their impacts must be stated on a consolidated basis, i.e., in the case of a revision affecting more than one period, adjustments must be accounted for in a sign-flagged manner. Profit and loss accounts must be closed separately so that the consolidated profit or loss impact of the revision can be accounted for at a general ledger level and excluded from the profit or loss for the reporting (current) year. The underlying logic to presentation in the report is that the impact of the adjustments affecting the balance profit or loss for the preceding year/previous years is not embodied in the profit or loss for the reporting (current) year; rather, it is to be interpreted as the profit or loss for the preceding period/previous periods. The balance sheet profit or loss for the preceding period must constitute part of the accumulated profit reserve in the balance sheet for the reporting (current) year. At a general ledger level, this logic-based report-level approach is reflected in Section 37(5) of the Accounting Act, pursuant to which, errors representing significant amounts identified in the course of a revision must be accounted for as items increasing or decreasing the accumulated profit reserve in the financial year when identified.

In the case of three-columned profit and loss accounts the column for the preceding year must contain figures identical with the closing data stated in the column for the business year immediately preceding the reporting (current) year. The column in the middle must contain all the adjustments for the preceding business year/previous business years on a consolidated basis, similar to what was presented in the case of the balance sheet.

It is important to stress that fundamental inter-connections between the balance sheet and the profit and loss accounts of the financial statements must also be reflected in the column for adjustments for the preceding year/previous years, i.e. the total amount of the assets and liabilities stated in the column in the middle and the balance sheet profit or loss figure in the balance sheet and the profit and loss accounts must be identical.

Furthermore, as regards the presentation of errors representing significant amounts in the report, pursuant to Section 88(5) of the Accounting Act, data on impacts on assets and liabilities must also be shown in the notes to the accounts broken down by year.

The Act on Accounting recognises the impact of errors representing non-significant amounts as part of the balance sheet profit or loss for the audited business years, which, in practice, means that the balance sheet and the profit and loss accounts of the financial statements for the reporting (current) year continues to contain two columns, profit and loss accounts affected by the revision must be closed concurrently with the closing of the profit and loss accounts for the reporting (current) period and the Accounting Act does not stipulate their presentation in the notes to the accounts.

Inclusion of the impacts of self-revision in the corporate tax

It is important that the adjusting items and legal implications identified during a self-revision should be separated in respect of corporate tax liability. Adjusting items may not constitute part of the corporate tax base for the reporting (current) year; accordingly, they are treated separately in accordance with the categorisation of the errors. As the impact of the errors influencing the data of the report significantly is not reflected in the profit or loss for the reporting (current) year, no item modifying the tax base materialises. Under the Act on Accounting, non-significant errors and their impacts must be presented as profit or loss for the reporting (current) year; under the Act on Corporate and Dividend Tax, however, the corporate tax base may only include the profit or loss for the reporting (current) year; it follows that they are adjusting items under Section 7(1)u) and Section 8(1)p) in the interest of the avoidance of double taxation, because they must be adjusted for the tax year in question in the self-revision return.  Under Section 7(1)r) and Section 8(1)e) of the Act on Corporate and Dividend Tax, the legal implications of self-revision, with the exception of self-revision charges (fines and late payment penalties), also mean adjusting items.